The eurozone isnt ready for the next big shock

posted onJun. 21, 2018 at 2:18 pm

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MADRID — The return to economic growth in the eurozone has produced a dangerous sense of complacency on the Old Continent, especially in the richer countries of the north. But Italys flirtation with an exit from the euro under a populist government is a stark reminder that, if left unaddressed, the deep structural weaknesses that plague the single currency could trigger an existential crisis across the EU. It would be a mistake, therefore, to believe we can drive along in business-as-usual mode, or just take a few small steps toward more European integration.

This weeks Mesenberg Declaration signed by Angela Merkel and Emmanuel Macron, although a step in the right direction, is part of a collective denial about what needs to be done. You dont need to be a populist to recognize that Europes monetary union is dysfunctional and in dire need of more substantial reforms that those proposed by Germany and France.

To keep the single currency alive, it needs two major structural improvements.

First, it needs to reduce the fragmentation in Europes banking system that has caused the Continent to experience more severe crises than other parts of the world — most notably in comparison to the U.S.

Second, it has to develop a streamlined and legitimate decision-making process to respond quickly and boldly to the next major recession.

The next crisis is likely to hit some countries harder than others. The problem is that the only tools at the eurozones disposal to tackle these recessions is through internal devaluations — which invariably lead to income cuts and job losses.

The European Commission, academics and national governments broadly agree on this diagnosis. The problem is that there is no consensus on the way forward.

Some argue that eurozone countries should take on more responsibility when it comes to prevention and reform. That means putting public finances in order, boosting the solvency of banks — by reducing the incidence of non-performing loans — and reforming their labor and product markets.

Action at EU level, according to this view, should only become an option when each country has taken the necessary measures to get their house in order. In other words, risks should be minimized before they are shared among the group.

But the experience of Spain and others shows that this approach, although it may work in normal times, tends to produce unnecessary economic damage during a crisis. The strategy of placing most of the burden on crisis-stricken countries under the adjustment logic of the so-called troika can — in the long run — prove to be politically unsustainable and undermine European citizens confidence in the euro. We saw it in Greece. We are now seeing it in Italy.

Yes, Germany carried out successful reforms in the early 2000s. But their success owes much to the fact that other European countries were sustaining demand for German goods and services. What might be good for one country can be damaging if several countries act at the same time.

We need to be more ambitious than simply proposing a eurozone budget. Designing a relatively well-sourced fiscal capacity, managed by a central fiscal authority, at the European level will be crucial to offsetting country-specific shocks.

This can take several forms: a European-wide fund to be mobilized depending on a countrys circumstances; an investment fund; or an unemployment reinsurance system that tops up national schemes. What matters is that it can be quickly activated in the event of a major shock and that there are safeguards to avoid irresponsible behavior.

This eurozone budget — which should be closer to €100 billion than the €10 billion presently foreseen — would smooth macroeconomic shocks and fund pan-European projects to increase growth potential, ensure sufficient public investment, reduce inequality, protect the borders and facilitate debt sustainability.

It would be an ambitious measure, and it can only happen if there is trust among member countries and a willingness to pool more fiscal sovereignty. For it to work, every member country would need the backing of its citizens.

Merkel and Macron neglect this point in their declaration. But the truth is that reform will be politically impossible without first explaining to voters why their government needs to contribute to a eurozone-wide fund, when it should be activated and how it should be deployed. The eurozone is, after all, a public good. Politicians have a responsibility to make a convincing case for why it needs a eurozone budget to sustain it.

They must also address the concern — common in northern member countries — that creating a central fiscal capacity will encourage some to misbehave and overspend.

This can be avoided with the right incentives. The new framework should be set up in a way that ensures that only countries that stick to fiscal prudence and commit to structural reforms will receive support.

The question of what happens when a member country misbehaves must also be answered. Introducing formal sovereign debt restructuring in the eurozone to ensure market discipline ex ante — as Merkel has suggested — is problematic.

As long as the central fiscal capacity is not large enough — and it wont be for some time — sovereign debt restructuring will be both traumatic and destabilizing for Europe as a whole. Instead, a member country should be able to obtain financial support from the central fiscal authority, while relinquishing its fiscal sovereignty temporarily, and signing a memorandum of understanding of macroeconomic reforms.

This fiscal authority would have to represent the interest of the eurozone as a whole and not the sum of the individual members, as is now the case with the European Stability Mechanism as well as the future European Monetary Fund proposed by Merkel and Macron.

To ensure this, the permanent head of the central fiscal authority should be put forward by the Eurogroup and ratified by a newly established euro committee in the European Parliament.

The bottom line is simple. For the eurozone to be successful, we need to inject more democratic legitimacy into how it is governed.

Miguel Otero-Iglesias is senior analyst at Elcano Royal Institute and professor at the IE School of International Relations. Raymond Torres is director for macroeconomic and international analysis at FUNCAS. They are co-authors of the paper “Quit kicking the can down the road: A Spanish view of EMU reforms.”